4/27/2014

The defense industry has "crushed the broader market in the past year," blared MarketWatch.com last week. This trend does not "align with what many pundits believed would happen in the face of a stagnant economy and spending cuts," the report said.

Bloomberg Government had more good news for defense firms in its annual study of top federal contractors for fiscal year 2013. Federal contract spending fell by 11 percent, from $516.3 billion in fiscal 2012 to $462.1 billion last year, but defense firms overwhelmingly dominate the rankings.

Industry insiders believe this run may be unsustainable. A projected plunge in Pentagon spending — when sequestration-level budgets return in 2016 — eventually is going to hit the industry hard, to a point where top companies will not be able to continue making profits as they are today, said Linda Hudson, former CEO of Pentagon contractor BAE Systems.

Even big-name contractors eventually will have to merge in order to stay financially healthy, Hudson said April 23 at a Bloomberg Government conference in Arlington, Va. Although the Pentagon in principle opposes mergers of top prime contractors because it undermines competition, fiscal reality will trump wishful thinking, Hudson said.

Wall Street's sunny optimism may not last, she said. "There are some serious storm clouds on the horizon." Shareholders today are "delighted by [top contractors'] quarterly financial results, record share prices and profits," said Hudson. "It is a very popular place for investors to be." Most of the gains, though, are the result of cost cutting and share repurchases. "You can only cut cost so much, you can only buy back so many shares," she said. "It is not sustainable."

How long this cycle of extraordinary financial performance will last is hard to predict precisely, she said. "We're on a precipice of an industry readjustment."

A wave of consolidations involving smaller firms already is underway, said Hudson. "I think that, without some significant change, we're not that far from seeing that in tier one suppliers, too."

According to a new report by the consulting firm PriceWaterhouseCooper, there was an "uptick" in deal volume in the aerospace and defense sectors in the first quarter of 2014. This might be an indicator of a "stronger year for mergers and acquisitions although the sector remains cautious, said PwC, in the absence of budget visibility beyond fiscal year 2015.

There is consensus in the defense sector that the political winds are not blowing in favor of higher military spending. The Bipartisan Budget Act capped defense spending for fiscal year 2015 at $495.6 billion. The Pentagon’s request complied with that top line, although it is asking for a $26 billion special “investment” fund. The administration is asking for an additional $115 billion between 2016 and 2019. The extra funds, the Pentagon claims, will avert steep cuts to ground and naval forces.

Defense officials said they are waiting for "signals" from Congress on whether it will go along with these requests. "I don't think we'll see any signals before the midterm elections," said Betsy Schmid, vice president of the Aerospace Industries Association. The mood on Capitol Hill is not going to be helpful to defense industry, she said. "There is no appetite to reverse sequester after the Murray-Ryan deal."

The best hope for the Defense Department is that Congress chooses to reevaluate sequester cuts across the board, not just for the military, Schmid said. If lawmakers see "huge holes and real pain [in nondefense programs], you'll see momentum to make small changes in the Budget Control Act caps." Although there is considerable support for military spending in some sectors on the Hill, said Schmid, Congress has far fewer defense hawks than it used to.

Hudson said that while Congress has the final word on budget decisions, the Executive Branch is also responsible for creating an uncertain business environment for defense industry. "The reductions in defense spending are not tied to any peace dividend that I can see," she said. "Perhaps we're cutting defense for financial reasons. But the policy is not clear. Where we're headed is not clear."

The lack of a cohesive national security policy irks CEOs, she said. "Rather than aligning with concise policy tied to funding that we can predict, industry is saying 'I'm not going to bet my future on something that I can't see or understand.'" Today's defense planning "just feels very disjointed and misaligned," said Hudson.

In her former position as head of BAE Systems, Hudson oversaw painful downsizing — the company lost about 30 percent of its workforce over the past several years — as the Army and Marine Corps slashed spending on armored vehicles. Only two companies currently build combat vehicles for the U.S. military: BAE Systems and General Dynamics Corp. Without explicitly suggesting that these firms should merge, Hudson said it is hard to see how both companies can stay in the combat vehicle business.

“Right now we have differences of opinion about consolidation and how we get there,” she said. “But I think that will be sorted out in a reasonable collaborative way.”

Everyone believes in competition, said Hudson. “But it becomes very difficult when you look at combat vehicles.” There are only two suppliers, and the largest program that was on the horizon, the Army's ground combat vehicle, has been terminated. It is not clear how the Defense Department can keep competition in an environment where there is barely enough work for one supplier, she said.

"Lots of conversations need to happen" on this issue, she added. The budget is a concern for the defense sector, but the larger problem is the absence of a broader national security policy, she said. "We are not working together as a national security industrial base, holistically," she said. "It is happening in a very fragmented and haphazard way."

Hudson's advice to industry leaders, however, is to buckle up. "Industry has to accept declining spending will be with us for some time," she said. "We have to find a way to make it work ... and innovate with less."

With big-ticket weapon programs under fire for their rising price tags, it would behoove contractors to help the Pentagon set realistic goals in the future, Hudson said. "Speak up when you think a requirement is stupid, and make a coherent argument on why it doesn't add value to the process," she advised her colleagues. "We have an obligation to figure out how to provide the best with the resources we can get. It's not just telling the government, 'Give me more money.'"

Elana Broitman, deputy assistant secretary of defense for manufacturing and industrial base policy, agreed that the industry faces tough times but she insisted that the Pentagon is not yet prepared to allow big-company mergers.

The outlook is "very challenging but the sky is not falling,” Broitman told the Bloomberg conference. The Pentagon understands that when defense budgets come down, the industry has to resize accordingly. But the sector already is small, she said. “We're concerned about continuing competition.”

She said the Pentagon’s stance against mergers of prime contractors has not changed. “We review every transaction. There have been a few mergers, we'll probably see more,” Broitman said. The Pentagon did block one recent proposal for a major industry merger, she said. “It's difficult to see how we can go lower than where we are right now.”

Broitman said the Pentagon will seek to boost U.S. manufacturers by helping to promote their products overseas. “Our industry competes around the world,” she said. “We would rather have U.S. industry win competitions.”

In its 2015 budget, the Defense Department is requesting funds for technology programs intended to bolster the industrial base, she said. Nearly a billion dollars was proposed for new engine technology. The Pentagon also is funding projects in sensitive industry sectors such as ground vehicles and missile components, said Broitman. Asked whether the Pentagon worries about the possible shutdown of Boeing’s F/A-18 fighter production line after current Navy orders end in 2016, Broitman said the Defense Department is in wait-and-see mode. “We continue to look at that very carefully,” she said. “It's such a difficult problem. It's a matter of funding. We'll see what happens.”

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